Even when implementing passive currency hedging strategies, it’s still important to think in terms of alpha, explained Jay Moore, a senior vice president at Brown Brothers Harriman (BBH), during a panel discussion at the Profit & Loss Forex Network New York conference.
Although this might initially seem to be a contradictory statement, Moore explained that providers of passive hedging services can differentiate themselves both through risk management and what he termed “operational alpha”.
While portfolio risk obviously isn’t a concern when implementing passive currency strategies, Moore explained that there is a strong focus on managing other types of risk, such as regulatory risk, operational risk and managing the fiduciary risk that managers have on behalf of the funds that they outsource to firms that are providing the passive hedging.
“I think for all of the providers, that’s the common starting point. If you can’t do those things well, the operational risk management side, you shouldn’t be in the business,” he said.
But beyond simply providing strong risk management, Moore claimed that firms providing passive currency hedging services can also differentiate themselves by offering operational alpha.
“So when you talk about alpha on the active side, you’re talking about boosting alpha. When we talk about operational alpha, we’re talking about preserving returns,” he said.
Moore explained that a poorly implemented passive strategy can bleed performance via a variety of implementation issues, such as transaction cost, timing lag, slippage and settlement failures. But these days it is not enough to simply ensure that this doesn’t happen, he said, firms need to offer greater transparency about how the passive hedging strategy was executed in order to demonstrate to clients that there was not a loss of performance.
“Clients want to outsource the process but not the control. So we need to be able to build tools so that ultimately, our clients can have the visibility and the oversight to be able to stand behind their decision to outsource, and that’s where I think the industry in the passive space has lacked for a long time,” Moore added.
Of course, demonstrating regular alpha in the form of returns is more straightforward than providing evidence of operational alpha, but Moore said that it is possible to do so via performance attribution.
“Performance attribution doesn’t sound so sexy in the passive space, but I assure you it is,” he said. “This has really become a demand in the market, the ability to show clients that when you have an asset that’s denominated in euros but you’re managing it from a US dollar perspective, translating it from euros to dollars has an actual currency effect…the expectation is that the P&L of your hedge should offset that and then any difference needs to be attributable to something related to the implementation of that programme, including and most prominently, the interest rate differential.”
Moore added: “But there are other costs involved; transaction costs, making sure that you’re reacting to new information on a regular basis and quickly so that you’re not creating timing lags, or implementation shortfall in other asset classes as it might be known. So having that ability to break down the performance in that way demonstrates that you’re doing your job well and you’re not bleeding alpha, but it also provides a sort of feedback loop into the process because maybe you want to tighten up your hedge ratio filters or widen them out because you’re trading too often. These are the types of things that bring value to clients and preserve alpha.”